Conflict: buy on the sound of cannons?

Ever since we left lockdown, the world feels like a more violent place. A military coup in Myanmar in 2021, Russia’s invasion of Ukraine in 2022 (plus the Taliban retaking of Afghanistan), Sudan and Gaza in 2023, and now further attacks throughout the Middle East.

With the exception of interest rate movements (and Brexit, back in the day), nothing creates more incoming calls and emails from investors than conflict.

It makes sense; we react to what’s in front of us. In previous decades it would have been the marching of boots, or the rumbling of tanks – now it tends to be the trails of rockets in the night sky which herald another clash. Pretty provocative.

And there are always two questions I’m asked.

Is the world about to end, and will my portfolio survive?

The glib answer is – of course – that so far, the world hasn’t ended.

But that isn’t the whole story.

Because there are assets which will be affected by conflicts. The sanctions applied to Russia following the invasion in 2022 rendered most Russian investments worthless in international portfolios. Occasionally, currencies will implode as investors lose confidence.

At the same time, other assets might do well. If supply is affected in some key good – wheat, or oil, or semi-conductors – prices might well rise. Or if a certain company is suddenly unable to operate, its competitors might get a leg up. But again, owning something, just in case of gunshots across the border isn’t a sensible investment strategy.

We make a big thing of diversification at 7IM. The more widely we spread your investments, the less likely we are to be over-exposed in any given area. That comes with a caveat, though – because we invest widely, we almost certainly will have some exposure in the affected area.

That’s the trade-off. A tiny bit of your portfolios was in Russian assets in 2022 – wiped out, gone, not coming back. But you also had a chunk in large UK oil companies, which had their best year in decades.

We’re fighting lots of different battles. And while we might lose the odd one, the aim is to win the war.

Should I buy defence companies?

Is there a simple equation? War = Defence Stock Boom?

Well, there’s certainly a market. In 2023, the world spent $2.4tr on defence¹. That was 6.8% more than 2022 – which is an extra $150bn. A huge pool of money, and it’s been growing fast. Partly, that’s been a response to Ukraine and more recently, the Middle East.

But investing in defence stocks isn’t quite as simple as buying more when there’s more fighting. The real driver of returns is a willingness from governments to increase military and defence spending on a structural basis – securing the funding (i.e., profits for the companies involved) over a decade, rather than just a quick order for a few extra tanks or missiles.

The real route to corporate success is being part of the long-term security infrastructure that supports global peace and stability. And if the rate of growth (6-7%) per year continues, then that’s hundreds of billions up for grabs in the next few years. The NATO agreement (and hence US Presidential election) will impact that too.

Now, it’s tough impossible to accurately predict specific geopolitical events (hence the diversification point above).

But my simple rule is that governments tend to solve for the most recent past crisis. And recently, the Western world found itself underprepared for three things:

So guess what... Pandemic planning is being beefed up, energy infrastructure is feeling the love, and defence departments are getting a lot more funding.

Unfortunately, a lot of that news is in the price already – at the time of publication, the MSCI World Aerospace and Defence index is up 55% since the start of 2022, while the broader global index is only up 14%.

That doesn’t mean there isn’t more to come; and our diversified investment approach means portfolios probably have a little more than the industry average in companies like BAE Systems, SAAB (they no longer make cars) and Qinetiq (a UK Ministry of Defence spinout).

But going back to what governments are spending money on, there are plenty of other structural opportunities which can be just as interesting. Pandemic preparation needs healthcare companies. Industrial energy transitions need raw materials.

Yesterday’s headlines can be just as good an investment opportunity as today’s - if you can take the long view.

The ethics of defence

One interesting nuance to note is that the recent trend towards ethical investing has led to a little bit of a lack of equity investment in the defence sector. Early ethical screens excluded defence stocks almost without thinking.

That’s changing. When he was Defence Secretary, Grant Shapps suggested that it was in fact unethical for ESG investors to avoid defence stocks – as world peace relied on them. It’s a bit of a stretch to say that view has fully taken hold, but signs are that this is changing. European ESG funds have more than doubled their defence holdings since 2022, and a recent study by HanETF² found that 94% of wealth managers now consider defence stocks to be eligible for ESG portfolios.

¹2.3% of global GDP https://www.sipri.org/sites/default/files/2024-04/2404_fs_milex_2023.pdf
²https://hanetf.com/periodic-reviews/thematic-digital-assets-review-h2-2024/